Three Ways the Economy Can Crash Land in New Year

The U.S. economy outperformed most expectations this year.

While the growth rate is currently slowing down, the “soft landing,” where the inflation rate dips to the Federal Reserve‘s (Fed) 2% target while the economy avoids a recession, is now a widely held view. However, America is not out of the woods. The current economic slowdown might still turn into a recession. Here are three ways that could happen:

High interest rates persist: Despite the recent discussions about interest rate cuts and falling long-term bond yields, the Fed’s policy rate target remains at 5.25-5.5%, the highest in over 20 years. According to the most recent Summary of Economic Projections, the Fed plans to lower rates only gradually. This means that the rates are likely to stay elevated for most of 2024. Even when factoring in a few cuts, the cost of credit remains high, posing clear risks for floating-rate lenders or any borrower who must refinance their loans over the next few years. This includes a large portion of the commercial real estate (CRE) loans due for over $500 billion of refinancing in 2024, as well as many private commercial loans. Potential solvency problems in CRE or the private-credit space are likely to affect the banking sector. Deteriorating credit quality and potential capital losses suffered by the banks would then lead to tighter financial conditions in the overall economy, which in turn could push America into a full-blown recession.

Labor market spins out of control: The labor market has softened somewhat in the past few months, as the unemployment rate increased, and the wage growth and the number of job openings per each unemployed person have declined. Still, the labor market remains tighter than in 2019. As the economy slows down, unemployment is likely to inch higher. While the Fed anticipates the unemployment rate at or slightly above 4% by the end of 2024 and staying there, engineering a “just right” softening of the labor market is a very delicate and precarious task. Once the unemployment rate starts increasing, there is a risk of a feedback loop turning on: Higher unemployment leads to a decrease in consumer spending, which lowers business profits, which in turn forces companies to lay off workers, increasing unemployment even more. This kind of feedback loop is typical for most recessions, and once triggered, it is very difficult to stop. Were the economic slowdown to set off such a loop, it might easily turn into a full-blown recession.

Inflation reignites: As inflation continues falling, the Fed will face increasing pressure to ease interest rates. While early rate cuts would help avoid the recessionary risks described above, premature easing might only shift it to a later time. If the Fed cuts rates before the inflationary pressures are extinguished, inflation might rekindle, forcing the Fed to raise rates again. Such tightening would likely mean higher rates for longer than expected, vastly increasing the risk of a “hard landing” featuring a severe recession. While the currently tight monetary policy carries some recession risks, easing too early might end up leading to a more severe recession down the road.

While bringing inflation down without triggering a recession is possible, it requires the Fed to time its policy well. Possible, but not easy.